Hedge Funds Use Basket Options to Save Billions on Taxes

Senate investigators claim in a report released Monday that hedge funds used a tax avoidance technique known as basket options to dodge federal leverage trading limits, saving one well-known trading firm around $6.8 billion in U.S. taxes.

The Internal Revenue Service, which warned in a 2010 memo against claiming a tax break based on the use of these so-called “basket options,” has been on the receiving end of some resistance by companies involved in the practice.

The report, delivered by the Senate Permanent Subcommittee on Investigations, suggests the practice has become rather common in the financial industry over the last 15 years, and even saved one hedge fund, Renaissance Technology Corp. LLC, an estimated $6.8 billion in federal taxes.

Investigators said that more than a dozen hedge funds used 199 basket options, purchased from Deutsche Bank AG and Barclays Bank PLC, to conduct more than $100 billion in trades.

The report claims that while most banks limited the sale of basket options as a way for hedge funds to claim long-term capital gains tax treatment, there are some who still sell the structures as a way around federal leverage limits.

The Senate panel plans to hold a hearing on the report on Tuesday and will hear from the hedge fund as well as the two banks involved.

“The [basket] options offered by Deutsche Bank which were discussed in the committee’s report were at all times fully compliant with applicable laws, regulations and guidance,” said Renee Calabro, a Deutsche Bank spokeswoman. “Moreover, they were a niche offering to a small number of clients over a discrete period of time which we completely ceased offering in 2010.”

Karrie Cohen, a spokeswoman from Barclays, said that “Barclays has been fully compliant with the law… and looks forward to continuing that cooperation at the hearing.”

Source: Mckinnon, John, “Senate Report: Tax Move Helped Hedge Funds Save Billions,” The Wall Street Journal, July 21st, 2014